Tuesday, August 27, 2013

Pensions Inflating an Infrastructure Bubble?

The $85 billion Future Fund has defended the price it paid for a stake in Perth Airport and dismissed concerns that infrastructure assets are in bubble territory.

The fund, which was established in 2006 to oversee the retirement savings of commonwealth government public servants, said fears that recent entrants to the market, such as global pension and endowment funds, had pushed up prices to unsustainable levels were overdone.

Future Fund chief investment officer David Neal said infrastructure assets were “certainly well bid”, but denied they were over-priced. “We are not in bubble territory. The market doesn’t feel frothy or bubbly,” he said.

The Future Fund said infrastructure investments continued to generate attractive returns for the prices paid.

“If you are a long-term investor, infrastructure provides long-term, stable, inflation-related income flows that are valuable. A lot of assets are providing just that,” said Mr Neal.“We think in general the prices being paid reflect the cash flows we expect to receive,” he said.

Earlier this year the fund stunned investors when it paid $875 million for a 30 per cent stake in Perth Airport, which was a 43 per cent premium to an independent valuation provided in June 2012. The stake was bought as part of a $2 billion deal with listed ­investment company Australian ­Infrastructure Fund (AIF).

Fund happy

The Future Fund’s head of infrastructure and timberland, Raphael Arndt, said the fund was happy with the prices it paid for the assets it acquired through the AIF deal, including ­holdings in Melbourne Airport, ­Sydney Airport and a clutch of European airports.

Separately the fund owns 17 per cent of London Gatwick in the United Kingdom and has stakes in airports in Europe and South America.

Mr Arndt said Western Australia’s biggest airport was particularly attractive because it had experienced massive growth in recent years and the car parks and terminals were now congested. As a result, there was an opportunity to upgrade the facilities.

Although Mr Neal said infrastructure assets were not overpriced, he said the current investment environment was difficult. Prices of growth assets, such as shares, had risen substantially in recent months, partly due to aggressive monetary easing by central banks, while government bond yields remained low.

“It is an interesting and really challenging time,” Mr Neal said.

“It is almost the first time in our ­history when we don’t see any sectors that stand out as being really attractive. It is starting to get a lot harder. No areas are screamingly expensive but across the board everything looks full,” Mr Neal said.

Pensions replace banks

Mr Neal said pension funds had replaced investment banks as big owners of assets such as roads, tunnels, pipes and bridges. Investment banks were largely forced out of the market after the global financial crisis due to tougher regulations and business models that collapsed under too much debt.

“[The investment banks] aren’t there any more,” said Mr Neal.

“[In some cases] we are seeing the new kids on the block,” he said.

In Australia infrastructure vehicles operated by Macquarie Group and the defunct Babcock & Brown have disappeared in the past few years.

The Future Fund said in March it had $5.5 billion of infrastructure and timberland assets, representing 6.5 per cent of total investments. It is believed that figure has since increased to $7 billion.

The Future Fund has been set a return target of between 4.5 per cent and 5.5 per cent over the rate of inflation over the long term.

It is due to report its performance for the 12 months to June 30 in the coming weeks. The average balanced superannuation fund posted an increase of 15.6 per cent last year.

But the question of valuations and paying too much for infrastructure assets is worth looking into. Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP), warned my readers about pension funds taking on too much illiquidity risk in this environment. Leo de Bever, President and CEO of AIMCo, recently told Bloomberg that real estate "keeps me up at night" and he warned investors three years ago not to rush into infrastructure.

Like all private assets, it's all about projected cash flows, what price you get in at and the long-term prospects of an investment. I recently wrote a comment on the risks of toll roads where I highlighted weakness in this sector and how exuberant projected cash flows turned out to be dead wrong, costing millions to private investors.

As far as airports, I commented on PSP Investment's big bet on airports, stating that they got in at an attractive price and this will prove to be an excellent long-term investment. In a recent article covering the $283 million new equity financing of Sydney Airport, Bruno Guilmette, senior vice president of PSP said: “Airports are resilient businesses with attractive cash flow profiles, and they fit well with our long-term investment horizon.”

I can't comment on the terms of the Perth Airport deal except that there is a legal dispute with another retirement fund, the $46bn Australian Super, which is seeking information on the sale claiming the bidding process was gamed to deter other shareholders including Australian Super from exercising preemptive rights. Future Fund denies any wrongdoing.

The managers are almost out of money from the 2006-2008 heydays when about 50 funds collectively raised close to $50 billion a year, mostly in private equity-style funds.

Last year, a little more than half that was raised, with most of the money going to just a few managers.

Industry Funds Management, for example, raised a total of $8.3 billion for an infrastructure fund last year. By contrast, CVC Capital Partners Ltd. called it quits on efforts to raise a e2 billion ($2.6 billion) infrastructure fund, even though it's about to close on a e10.5 billion leveraged buyout fund.

Infrastructure fund managers closed on $26.9 billion last year, down 67% from the $44.8 billion raised in 2008.

Concentration of assets in the hands of a smaller group of managers will cause a drop-off in the number of infrastructure managers, with managers focused on stable, income-producing investments especially vulnerable, said Duncan Hale, senior investment consultant and head of global infrastructure at Towers Watson & Co. in London.

There's pressure on infrastructure managers' business models that will result in some managers merging and others fading away over time, Mr. Hale said.

Traditional infrastructure vehicles have a five-year investment period, which means many of the funds raised in 2007 and 2008 are coming to the end of the their investment periods — the time in which managers have to spend the capital raised. Now, these same managers are out raising their next funds, and are finding less money being invested in infrastructure, Mr. Hale said.

According to London-based alternative investment research firm Preqin, 144 infrastructure funds are attempting to secure a total of $93 billion from increasingly choosy investors. While there has been an increase in institutions creating broad “real asset” portfolios, infrastructure assets dropped 10.4% as of Dec. 31, according to the most recent of Pensions & Investments' annual surveys of managers of U.S. institutional, tax-exempt assets.

“There's a smaller pie for people to take a piece of,” Mr. Hale said, and most of the pie is being taken by a handful of managers.

Winners and losers

“Winners are raising lots of money and losers are not necessarily raising any,” Mr. Hale said.

Indeed, the 10 largest infrastructure money managers accounted for 45% of the capital raised in closed-end funds in the 10 years through June 30, according to Preqin. The top 10 managers raised $103 billion of the $231 billion raised over the past 10 years.

To survive, some managers are testing different models, Mr. Hale said. They are considering changing to funds with investment periods that last 10 to 15 years or to an evergreen approach, with funds lasting even longer, he said. Other managers are starting to invest in infrastructure debt and advising the very largest investors looking to make direct investments in infrastructure.

However, Mr. Hale noted, “for most investors, investing in well-aligned pooled funds is a better governance solution for them than owning these assets directly.”

Still, offering an open-end structure is not a foolproof recipe for survival. J.P. Morgan Asset Management's infrastructure business has gone through some growing pains. There has been some rejiggering in the executive ranks that culminated in March with Paul Ryan being named CEO of OECD infrastructure equity and debt from his post as a managing director and co-head of the bank's public finance banking unit.

“Unlike private equity, in infrastructure — really the whole real-asset area — there has not been a preferred fund structure,” said Stephen Nesbitt, CEO of alternative investment consulting firm Cliffwater LLC, Marina del Rey, Calif. “There are some open-end structures, partially open-end structures and closed-end structures and the deal terms can vary significantly.”

Markus Hottenrott, chief investment officer of Morgan Stanley (MS) Investment Management's infrastructure unit in London, contends the open-ended model only works for core infrastructure assets. Even then, he said, the “ideal holding structure” for core infrastructure — which he defines as assets that realistically justify 8% to 10% target internal rate of returns — is direct ownership by institutional investors such as pension plans, sovereign wealth funds and insurance companies.

However, direct investing requires a certain critical mass to build and maintain an internal team, he said.

Some investors are seeking alternatives to the private equity, closed-end model, but open-end funds are not necessarily the answer, Mr. Hottenrott said.

“Some people argue that because infrastructure investing is in long-dated assets, there should be long-term capital structures, i.e. long-term debt,” he said. “They may ask themselves, "Shouldn't we have open-ended, perpetual exposure to these assets?' The reality is there have not been that many (open end) funds.”

Much of what is happening in the industry is the result of growing pains of a relatively new asset class, said Mathias Burghardt, senior managing director and head of the infrastructure group at AXA Private Equity, Paris.

A number of firms were raising massive infrastructure funds and spending heavily before the 2008 financial crisis, Mr. Burghardt said. “They were paying sometimes aggressive prices and the debt was quite cheap,” he explained. “When the crisis hit, the largest players were hit more than others and so a lot of U.S. managers, particularly U.S. bank-managed funds, were hit hard.”

Many struggling now

Many firms are struggling now because they paid too much for assets and used too much debt then. “They were too eager to deploy money,” he said.

Again, there are limits.

AXA Private Equity finished raising a e1.8 billion infrastructure fund in March, including a e300 million co-investment vehicle. He attributed the success to the addition of new, mostly European and Asian investors to the mix of investors.

“U.S. investors show interest, but are worried about the European economic situation. But my impression is that they are getting over that,” he said.

In the end, it's all about returns, said Marietta Moshiashvili, New York-based managing director and portfolio manager of TIAA-CREF's private infrastructure portfolio.

Many of the managers that raised funds before the crisis were raising infrastructure funds for the first time. Now that investors have track records on which to base their investment decisions, some managers have not been able to raise a second fund and have stopped fundraising.

“We are seeing fund managers that are not as successful, and some are offering mixed messages to the market,” Ms. Moshiashvili said.

But it is part of the maturation of the asset class.

“There's more clarity in defining winners and losers in the industry,” she said.

Indeed, it's part of the maturation of the asset class. The industry is going through a needed shakeout. There will be winners and losers and just like in private equity, real estate and hedge funds, money will be concentrated in the hands of a few top funds.

But it's important to remember that infrastructure is a long-term asset class, much longer than real estate and private equity. And some pension funds, like OMERS, are world leaders when it comes to direct investments in infrastructure. OMERS Borealis recently announced it is planning to open an Australian office and they've been busy on many infrastructure deals, including a recent transaction with Allianz to complete their purchase of Net4Gas.

Also, aiCIO reports that some of the largest investment pools have stepped up their infrastructure buys in the past 18 months:

In July, the once very conservative Japanese Pension Association, a federation of employees' pension funds, joined the Ontario Municipal Employees' Retirement System (OMERS) in a purchase of the gas-fired power station in Michigan.

Today, PensionDanmark, the DKK139bn (€18.6bn) Danish pension provider, announced it was helping establish a mine in Armenia with financial backing worth $62.7 million. The money is being made available to the company building the mine, Teghout CJSC, so it may purchase equipment from Danish engineering firm FLSmidth.

Torben Möger Pedersen, CEO of PensionDanmark, said the deal was killing two birds with one stone: “On the one hand, the partnership will ensure a return for our members well above the bond rate, and on the other hand it will help make more Danish export orders possible at a time when more traditional financing is difficult.”

In sum, infrastructure is an important asset class for pension funds looking for long duration assets. There is a shakeout going on in the industry but talk of an "infrastructure bubble" is way overblown, leading investors to conclude there are no opportunities worth investing in this space. There are opportunities and pension funds with expertise in this space will find them and do well over the long-run.

Nonetheless, infrastructure investments can sour and investors should tread carefully, especially if they have no experience in this asset class and don't know how to approach it. A friend of mine who is an expert in infrastructure tells me there will be a "big cleanup" in the future as many infrastructure investments are badly managed and investors will need "operational advice" to get out of very messy situations. "The investment banking types are great at striking deals, terrible at managing infrastructure assets."

After reading my comment above, my friend shared this with me:

"Not sure I agree with all your conclusions but you covered the topic well. The fundamental issue comes down to pricing. Are funding providers generating enough spread across a portfolio of transactions to cover losses if a few transactions do not go as planned? I am not yet convinced because this asset class has not gone through enough business cycles to understand the risk/reward relationship completely. Also, the definition of infrastructure seems to mean different things to different people and projects with very different risk profiles are being lumped into the same asset class."

Below, more evidence on the risks of toll roads. Road traffic has fallen more in Portugal than in any other European country in the past 15 months. Peter Wise, FT's Lisbon correspondent, reports on why empty roads provide a revealing insight into the depth of the country's recession.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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